August 13, 2009

Not So Fast, Obama

With Republicans blaming the stimulus for every sagging stock price and shrinking paycheck, you could hardly begrudge the White House for touting some good economic news these last few weeks. In late July, the Commerce department reported that GDP had shrunk by an unexpectedly mild 1 percent, prompting the president to observe that, “in the last few months, the economy has done measurably better than expected.” A week later, it was the labor market that brought a pleasant surprise. Upon learning that the economy shed just 247,000 jobs in July (the least since last August), the president took to the Rose Garden to suggest that “the worst may be behind us.”

To its credit, the administration has hardly gotten carried away with these pronouncements. Publicly, officials now refer to the economy as a once-deathly ill patient that’s stable but still sick--hardly a triumphalist metaphor. Privately, administration officials point to Bush’s May 2003 “Mission Accomplished” speech as a cautionary tale and shrink from any suggestion that they’re claiming victory.

To the extent that there’s a problem, it’s not so much what the administration says as what it assumes: that the business cycle exerts a solid gravitational pull, that what goes down must eventually come up. “[B]ecause of the Recovery Act, other rescue measures we have taken, and the economy’s natural resilience, most forecasters are now predicting that GDP growth is likely to turn positive by the end of the year,” Christina Romer, head of Obama’s Council of Economic Advisers, said in a speech last week (emphasis added). Romer went on to stress that 70 percent of the stimulus will be spent by next October--implying that growth should be largely self-sustaining beyond that.

But what if that’s not the case? Even granting that the worst is over, will the economy really be poised for steady growth just a year or two after the deepest recession since the 1930s? And, if not, can the White House afford to wait much longer?

Pretty much everything we know about the recessions that follow financial crises suggests that they last for an exceptionally long time. The reason has to do with a distinctive feature of these recessions: vast oceans of debt. During boom times, as a recent IMF report explains, people save less and borrow more, leading to a surge of consumer spending. But once the crisis hits, overextended households abruptly retrench. Saving shoots up as they pay down their debts; consumption plummets and can languish for years.

Late last year, the economists Carmen Reinhart of the University of Maryland and Ken Rogoff of Harvard sought to quantify the length and intensity of recessions that follow financial crises by looking at several recent examples. What they found was alarming: On average, the countries they studied saw their housing markets drop 35 percent (from peak to bottom) over a stretch lasting five to six years. Their stock markets fell 56 percent over three-and-a-half years. Unemployment rose 7 percentage points over five years, and GDP dropped a breathtaking 9 percent over two years.

The good news is that, by the standards of the Reinhart and Rogoff paper, we may be nearing the end: U.S. housing prices had dropped by about one-third as of May, and the S&P 500 had lost about 53 percent of its value when it hit bottom in February. The unemployment rate is up about five percentage points since its 2007 low, suggesting that some pain remains, but far less than we’ve suffered already. And while GDP has only contracted by 4 percent--less than half the average from the Reinhart and Rogoff study--the authors explain that such declines tend to be less severe in developed countries than developing countries, which are vulnerable to abrupt withdrawals of credit by foreign banks and investors. Long story short: One can certainly be acquainted with the Reinhart and Rogoff analysis, as the administration’s top economic officials are, and still believe we’re only looking at another year or two of misery.

The problem with whatever optimism you might draw from Reinhart and Rogoff is that their conclusions come with an enormous caveat attached: Almost every country that’s emerged from a recession caused by a financial crisis has exported its way out of the mire. “[T]hese historical comparisons were based on episodes that, with the notable exception of the Great Depression in the United States, were individual or regional in nature,” the authors note. “The global nature of the crisis will make it far more difficult for many countries to grow their way out through higher exports”--since no country is flush enough to serve as a dumping ground for everyone else.

Absent a strong demand for exports, the most plausible way for a country to crawl out of this kind of recession is for households to keep paying off debt until they can afford to spend again. Indeed, as Paul Krugman argued in a recent lecture series at the London School of Economics, the reason the United States didn’t slip back into depression after World War II--something many economists feared at the time--is that, 15 years after the initial crash, people had finally put their finances in order.

Unfortunately, as the Depression example suggests, this can take agonizingly long. According to data from the Federal Reserve, household debt peaked at 128 percent of disposable income in 2007 (meaning the average person was borrowing* almost one-third more than they were making after taxes). As of the end of March, despite a dramatic rise in saving after the crisis hit, that ratio had only fallen to 123 percent. (The same ratio stood at under 50 percent in the mid-’50s and around 70 percent as late as the mid-’80s.) A recent San Francisco Fed paper notes that it took Japanese companies, which had a similar level of indebtedness when their real-estate bubble popped in the early ’90s, about a decade to push the ratio down to a still-high 95 percent.

Alas, it’s hard to believe voters will wait a decade for something resembling normal growth. Even three years’ worth of patience seems like a lot to ask--which presents a problem for a president who has to run for re-election in 2012.

So far as I can tell, the only solution to the underlying economic problem is something that’s been a dirty word in Washington the last generation or two: industrial policy (that is, an active government role in the development of certain industries.) In his LSE lectures, Krugman quipped that “if someone could invent the 21-st century moral equivalent of the railroad, or actually even the moral equivalent of IT in the ’90s, that would help a lot.” I agree--that would help a lot. But waiting around for this to happen seems risky when the alternative is a decade of stagnation.

If, on the other hand, the government were to place some massive bets on R&D, we might substantially increase our chances of stumbling onto a major technological breakthrough--or at least accelerate the process. True, industrial policy is a lousy idea under normal circumstances: Any invention with lucrative commercial applications should have a high enough expected return to attract private capital Using government money to fund progressively longer shots is likely to be wasteful. (The exception is technology that would be socially useful but whose commercial applications aren’t immediately obvious.) But, in a deep recession like this one, the case for industrial policy gets much stronger. At worst, the additional government spending would inject some needed stimulus into the economy. At best, it might yield a technological breakthrough that could attract a subsequent wave of investment and make growth self-sustaining.

In fairness, the White House has already been thinking along these lines. Last week, it announced $2.4 billion in grant awards to companies working on the “next generation of batteries and electric vehicles,” money that was allocated under the stimulus. But while a whole lot better than nothing, $2.4 billion is pretty meager given the scale of the problem. Why not 50 times that amount, spread out over dozens of promising fields--like solar power and nanotechnology? It’s an ambitious approach that would no doubt be controversial (though there are politically tougher tasks than handing out $100 billion to corporate America). But it sure beats waiting for that recovery to materialize … sometime in 2018.

Noam Scheiber is a senior editor of The New Republic.

CORRECTION: This piece originally stated that "the average person was spending almost one-third more than they were making after taxes." The line should have said "borrowing" rather than "spending." We regret the error.